Germany Spares the Risk with New Deutschland Bonds

Germany is poised to spare debt investors from making the stark choice between safety and decent returns by offering them both.

The government is expected to make good on its previously announced plan to issue debt jointly with some of the country’s federal states, known collectively as Bundesländer.

The German Finance Agency said it intended to issue so-called Deutschland bonds back in December when it outlined its 2013 funding plans but stopped short of giving details of timing or how much such issues would be worth.

On Tuesday, one of the banks arranging the meetings said Germany is planning to meet investors about its debut state- and federal-backed bond.

Barclays, Commerzbank, Deutsche Bank, DZ Bank and HSBC Holdings are the banks hired to run the inaugural sale. The German Finance Agency said the bond is likely to be around €3 billion euros ($4 billion) in size, with a maturity of five to 10 years.

For the sake of comparison, the typical auction size this year for a German two-, five- or 10-year federal debt auction has been €4 billion to €5 billion.

With German bonds currently trading at historically low yields, this new instrument may be attractive for those who prioritize safety but would prefer not to sacrifice returns.

The move should also benefit the bond issuers.

AFP

The joint issue is intended to help provide funding for German regions that have shaky finances and high borrowing costs. By having the federal government on board they can borrow money at more affordable levels.

Such joint bonds have also been suggested as a means to raise some of the €8 billion ($10.67 billion) the federal government and state governments want to put into the new funds to finance the cost of the recent floods in Bavaria and Eastern Germany.

In effect the government’s participation makes investors less fearful of a default. Nonetheless, in the new Deutschland bond all participants would be liable up to the amount of their own share of the issue.

Commerzbank 's rates strategists say the new bond will essentially look like established jumbo covered bonds issued jointly be federal states, or Länder Jumbos, but with a component from the federal government.

“The natural pricing benchmark should be the joint-Länder Jumbo curve with the Bund [federal government] share suggesting a slightly tighter pricing,” said strategist Rainer Guntermann in a note. “This first of all implies that financially weaker Länder [federal states] should enjoy somewhat cheaper funding conditions due to the credit enhancement from the Bund [federal government] component and the liquidity effect,” he said

The federal government’s participation would allow a higher trading activity in the paper.

Commerzbank said the Bund component could mean a somewhat cheaper funding for some of the weaker regions as investors may view the effective probability of a default rather in accordance with the credit quality of the strongest participant, namely the federal government.

Nonetheless, Commerzbank doubts that Deutschland bonds would trade close to Bunds, given the higher complexity of the instrument. Nor does it expect any noticeable pricing impact on outstanding Bunds, given the likely small federal government share in the instrument.

The federal government collects the bulk of taxes levied across the country and re-distributes part to the states which, themselves, have only limited ability to raise tax income.

Around one in four of Germany’s 16 states are initially expected to skip the issuance.

“We will look at the paper because in principle it’s interesting,” said Ruediger Kerth, portfolio manager for fixed income at German assets manager Union Investment, which had €190.5 billion assets under management at the end of 2012.

“The yield premium over German federal bonds and the expected liquidity are interesting,” Mr. Kerth said.

However, smaller asset managers who can be more flexible due to their smaller size may not want to buy into the Deutschland bond.

“The bond will definitely find buyers,” said Egbert Sauer, partner and fixed income portfolio manager at Lupus alpha Asset Management AG, adding that safety oriented investors buy out of conviction. However, Lupus alpha, which currently has €5.5 billion euros of assets under management, wouldn’t buy.

Lupus alpha will continue to prefer German Pfandbriefe–a form of covered bonds–as long as these Pfandbriefe offer even a “marginally” higher return than the planned Deutschland bond,

“The large liquidity of the planned Deutschland bond will be important only for very big funds,” Mr. Sauer said. Flexible asset managers like Lupus alpha can instead focus more on returns.

Citigroup strategist Peter Goves said that given that credit quality in many German states is similar to the German government’s, an ability to pocket higher returns than offered by government debt may lure buyers.

“In a hunt-for-yield environment, where spread pick-ups are a primary concern, we believe Deutschland bonds will act as another fundamentally strong alternative to Bunds,” Mr. Goves said.